MW The 'Magnificent Seven' are out; these stocks are in - but there's one catch

By Cam Hui

Japanese yen carry-trade unwind could again tank the stock market

The contenders for the market's new leadership are value stocks and defensive sectors.

Here's where the U.S. stock market is right now. The large-cap growth, old leadership is faltering, and different candidates are vying for the top spot.

The RRG charts tell the story. Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which becomes improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

An analysis of RRG rotation shows that growth sectors - namely technology, communication services and consumer discretionary, which are dominated by "Magnificent Seven" giants Amazon.com $(AMZN)$ and Tesla $(TSLA)$- are weakening. While technology and communication services remain in the top right leading quadrant, they are likely to fall into the bottom right weakening quadrant in the near future if they follow the normal clockwise rotation pattern.

The contenders for the new leadership are value stocks - financials, industrials, energy and materials - and defensive stocks, consisting of healthcare, consumer staples, utilities and real estate. A growth-to-value stock-market rotation would mean a bullish and benign internal rotation for stock prices, while the emergence of defensive sectors as market leaders is a signal of a market pullback.

A sector leadership review

I review the relative returns of the different sectors for some clues. A review of the relative performance of the growth sectors shows that only communication services has shown consistent positive relative strength. The relative performance of the other two sectors can only be best described as choppy.

The Nasdaq-100 NDX, which is a proxy for growth stocks, is also exhibiting worrisome market internals. Even as the Nasdaq-100 broke out to all-time highs, the relative returns of the "Magnificent Seven" stocks (bottom panel, red line) has faltered. This is another sign of weakening large-cap growth leadership.

The relative performance of the cyclically sensitive value sectors does not inspire high confidence in their leadership qualities. Financial stocks have seen a bid, but that's probably attributable to the anticipation of further deregulation, which benefits banking profitability. The relative returns of the other value sectors are choppy, though materials stocks may be trying to form a relative bottom.

The relative performance of defensive sectors are all showing signs of bottoming patterns, but they have not exhibited definitive signs of leadership qualities that indicate the bears have taken control of the tape.

Liquidity headwinds

What could tip the market into a pullback instead of a rolling correction? One headwind it faces is diminishing banking-system liquidity.

Stock prices have been correlated with liquidity, but liquidity has been going sideways for several months while the S&P 500 has advanced.

Bitcoin (BTCUSD) has been regarded as a real-time proxy for liquidity, which has shown a strong correlation with the S&P 500. Bitcoin has begun to diverge negatively against the stock market in the past few weeks.

Watch the yen

Another tail risk to consider is the potential of a repeat of the yen $(USDJPY.FOREX)$ carry-trade unwind, which sparked a sudden risk-off episode last August. Yields on Japanese government bonds have recently surged as the Bank of Japan's monetary policy has turned more hawkish, which puts upward pressure on the yen.

Further yen strength that moves the U.S. dollar (DX00)-yen exchange rate decisively below the 150 level could spark another risk-off episode.

What's next for stock investors?

Where does that leave investors? The S&P 500 staged marginal upside breakouts to a marginal all-time high last week, led by the Nasdaq-100. Both indices weakened below support-turned-resistance and tested their respective 50-day moving average $(DMA)$. The equal-weight S&P 500 XX:SP500EW never staged an upside breakout, and the S&P MidCap 400 MID and small-cap Russell 2000 RUT are languishing below their 50 DMA.

From a technical perspective, further S&P 500 weakness could target the price gap that begins just below 5,900. Keep in mind, however, the S&P 500 closed on Feb. 21 at roughly the level seen on Inauguration Day. It remains to be seen whether the "Trump Put" would activate should stock prices weaken further.

Major sources of volatility in the coming week will be the Nvidia $(NVDA)$ earnings report and a decision on the delayed 25% tariffs on Canada and Mexico that should be forthcoming. Mr. Market seems to be shrugging off the tariff threat by focusing on Trump's pro-growth policies and believing that tariffs are only a bluff. This is not the kind of environment to be taking on more risk.

In conclusion, a sector-rotation analysis reveals a market lacking in leadership, divided between a scenario of a rolling rotation from growth to value or a corrective pullback. My base case calls for a minor correction. The market faces several cross-asset headwinds from weakening banking system liquidity, a threat of a replay of the yen carry-trade unwind and renewed threats to growth from a trade war.

Cam Hui writes the investment blog Humble Student of the Markets, where this article first appeared. He is a former equity portfolio manager and sell-side analyst.

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-Cam Hui

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February 24, 2025 08:09 ET (13:09 GMT)

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